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The Shot Heard 'Round the ETF World

I'm not much of a country music fan. But I've always liked David
Allan Coe's rendition of
You Never Even Called Me By My Name
. As the lyrics tell us, the song was written by the late, great
Steve Goodman, who considered it the perfect Country & Western
song.

But Coe argued that it fell short. After all, the song said nothing
about mama, or trucks, or prison -- topics that no self-respecting
country ballad could do without. That critique prompted Goodman to
add a final verse about mama's unfortunate demise in the rain, the
perfect ending to what both agreed was the perfect song.

I'm reminded of this because exchange-traded funds (ETFs) just got
their own final verse and may now be the perfect investment
vehicle. These funds have always offered razor-thin fees,
transparent portfolios, intra-day liquidity, and stellar tax
efficiency. But until now, they haven't had a true portfolio
manager calling the shots.

And in my book, the greatest funds usually have a captain at the
helm, particularly in inefficient emerging markets that require
careful navigation.

Fans of passive management might view this as heresy: How can an
ETF newsletter editor prefer an active portfolio manager to a fixed
index ? Wasn't the entire industry built from the Bogle-esque
notion that investors could do just fine sticking with low-cost
funds tied to static benchmarks like the S&P 500? Answer: Yes,
it was.

But once upon a time,
Apple (Nasdaq: AAPL)
was just an obscure PC company, and ESPN was created to broadcast
University of Connecticut basketball games. Clearly, times change,
and the ETF world continues to evolve and branch out from its roots
on an almost daily basis.

Sure, you can still track the S&P or the good-old Dow Jones if
you like. But you can get the same thing with a low-cost mutual
fund from Vanguard and save yourself the commissions and trading
fees. Limiting your ETF exposure to these plain-vanilla indexes is
like dining at an extravagant seafood buffet and nibbling on a
cracker.

I'm not sure where or how it first became fashionable to base key
market barometers on size alone. We would never walk into an auto
dealership and ask for the heaviest car on the lot. But there are
trillions of dollars in assets linked to a small handful of
behemoths like
Exxon Mobil (
XOM
)
simply because of their market cap girth -- with no regard for
valuation, profit margins, returns on equity or any other
fundamental measure.

Years ago Wisdom Tree recognized that traditional indexing
methodology systematically pumped more dollars into overvalued
stocks that had risen and less into undervalued stocks that had
fallen. So much for "buy low, sell high." To sidestep that
fundamental flaw, the company began weighting index components by
more intuitive metrics like earnings and dividends.

Others have followed. RevenueShares, for example, assigns
weightings based on sales -- the more cash a company brings in, the
louder its voice in the index. Last I checked, the firm's funds
were clobbering the market at the small, mid and large-cap levels
through both growth and value-led market cycles.

Still other issuers like PowerShares have used powerful
quantitative tools to develop narrow, quasi-active indexes that
cherry pick potential leaders and weed out laggards. And we've even
seen ETFs that target stock buybacks, profit from M&A
arbitrage, and replicate hedge fund strategies.

We've come a long way from the pioneer days in the mid-1990s.

But this latest step in the evolutionary process is arguably the
biggest -- true active ETFs.

This group of funds is still in its infancy, but the 20 or so
active funds now on the market have already attracted more than
$340 million in assets. Expect that total to be measured in the
billions in the near future.

I've warned time and again that most fund managers charge
exorbitant fees for the privilege of delivering mediocre
performance. And indeed they do. But some stand head and shoulders
above the crowd.

Look at guys like Bill Gross, whose Pimco Total Return has topped
96% of all bond funds during the past 15 years, or Brian Rogers,
who has steered T. Rowe Price Equity Income to a cumulative gain of
+1,259% since the fund's inception in 1985.

These seasoned pros more than earn their paychecks and they're a
big reason why mutual fund assets still dwarf ETF assets by a wide
margin . But evolution is usually a slow process. The tide is
turning, forcing Pimco and T. Rowe Price (among others) to throw
their hats into the ETF ring. Even staunch indexers like iShares
will soon be testing the active waters.

I'm not sure how David Allan Coe feels -- but adding professional,
alpha generating portfolio managers to the steady rhythm of an ETF
sure sounds like music to my ears.

Nathan Slaughter
Editor: Market Advisor, The ETF Authority

P.S. -- I'll keep tabs on these funds going forward,
highlighting favorites for my newsletter, The ETF Authority. To
learn more about the newsletter, click here. And to sign up for my
free ETF course, go here.

Disclosure: Nathan Slaughter does not own shares of any security
mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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